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Intercompany Loans Growing in Captive Portfolios

Healthcare reform boosts interest in using captives for benefits.

Intercompany loans and other intercompany investments are currently the single largest investment allocation for corporate captive insurance companies, according to an annual survey of captives conducted by insurance brokerage Marsh. Other trends occurring in the captive industry include a surge in small captives and growing interest in using captives for employee benefits in the wake of healthcare reform.

The survey shows that the 1,148 captives Marsh has under management hold an aggregate 34 percent of their investment portfolios in intercompany loans or other intercompany investments. The next largest allocation is to fixed-income securities, which make up 32 percent of the investments in captives’ portfolios.

Marsh says the financial crisis, which lowered the return on fixed-income investments and put a premium on funding, encouraged captives’ use of intercompany loans.

In the years before the financial crisis, “you didn’t see a lot of intercompany loans because they didn’t need to,” said Michael Serricchio, senior vice president in Marsh’s captive advisory group. “They were earning 5 percent in the captive. When the credit crisis came on is when you had companies needing to borrow, and borrowing at 5 percent to 8 percent, while the captive was only earning 0.5 [percent]. That’s the whole reason for the loan back.”

The Marsh report predicts a “steady increase” in captives’ use of intercompany loans and cites regulators’ increased comfort with them, which it links to the practice of securing the loans with collateral such as accounts receivable or mortgages.

According to the survey, 18 percent of intercompany loans are backed with collateral.

Serricchio said he expects more use of collateralization. “It’s a more clean and a more arm’s-length way of transacting a loan or an intercompany investment,” he said. “An insurance company wouldn’t lend funds without some collateral, so why would a captive? That is the thought process.”

Serricchio said, though, that as the Federal Reserve begins to tighten monetary policy and the yields on fixed-income securities rise to more attractive levels, fixed-income investments could become more attractive for captives.

Michael Mead, president of M.R. Mead & Co. and editor of Captive Insurance Company Reports, questioned the notion that intercompany loans are increasing. “It’s one of those things that’s always been there,” he said. “I haven’t seen any real uptick.”

Captives are generally cautious in their investment strategies, Mead said. “If anything, I’m seeing a more conservative approach today,” he said. “There was a time 10 years ago when there were a lot of off-the-wall investments on their part—private homes, yachts, art works—and the IRS really cracked down hard on that.”

According to the Marsh survey, smaller allocations in captive portfolios include 21 percent held in cash and cash equivalents, 9 percent in alternative investments including hedge funds, and 4 percent in equities.

The substantial allocation to cash reflects captives’ need to pay claims, Mead said. “The key with a captive investment portfolio is matching up the projected claims payments to the expiration of the investment,” he said. “You’ve got to have the cash on hand. So the regulators pretty much push hard for short-term liquid investments, and that has not changed.”

If a captive qualifies as an insurance company, the parent company’s premium payments are tax deductible. But Marsh found that just 37 percent of the captives were treated as insurers.

Serricchio, pictured at left, said that while he was surprised by that number, “it proves that many captives are being set up for business and risk management reasons, not for tax.”

The Marsh report notes that many companies forming new captives are implementing “small captives,” captives that write less than $1.2 million in premiums and, provided they qualify as an insurer, can choose to be taxed only on investment income.

Small captives “are sweeping the marketplace,” Mead said, adding that the formation of small captives has been picking up steam for the last three or four years.

Adding Benefits

A more recent trend involves employee benefits in captives, he said.

A lot of big companies are self-insured for health coverage, as are many midsize and small companies. Mead said companies that are self-insured and have a stop-loss policy, which guards against very large claims, are considering using a captive for their stop-loss policy.

“There are taxes under the Affordable Care Act that don’t apply to self-insurance, so people can save themselves some money and a lot of headaches by being self-insured,” Mead said. “Then they put the stop loss into a captive, which is also not regulated under the Affordable Care Act.”

According to the Marsh survey, 18 percent of captives are insuring third-party risk. Serricchio said that such third-party business occurs at about the same levels in Bermuda, the EU, and the U.S.

“You’re going to have things like pooling in Bermuda and the U.S.; you’re also going to have a lot of extended warranties and benefits in the U.S. But you’re going to have a good share of third-party risk in Europe as well,” he said. Serricchio noted that 30 U.S. companies are currently covering ERISA employee benefits in their captive.

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